My Diary 361 --- A Foundation for Improvement; TARP-III and Its Weakness; We Have Earnings Slump; The Repetition of 2001-02

March 29, 2009

“Selective Listening: The South China Sea Confrontation, The New Reserve Currency Regime and The North Korea satellite launch” --- These are the hottest geopolitical and economic issues widely seen on the headlines of global medias over the past two weeks. My question is which side of the counter-party stories you choose to believe? You may ask why I think about it? Oh yes, this is more like a social behaviour topic but it has a strong correlation with financial market. My latest observation is that the market seems to have adopted selective listening - in general, negative news, except the very serious one such as government investigation, has been dismissed as "priced in" while any hints of positive news, rumours of government stimulus measures, BTE sales, asset reflation story, to name a few, would trigger strong rally. Thus, this rally has been driven largely by news flow riding on fund flow rather than fundamentals. The fact that the global financial crisis is far from over is already common knowledge - the question is how far can the bear market rally go? Another interesting observation is that the latest announcement of PPIP seemed well received by the markets and the data releases, while still extremely weak, are likely to show that the pace of deterioration is decreasing somewhat. But there is a general disconnect between the markets and Nobel Prize Winners (or professional forecasters) on the economic outlook and the Geithner plan, with the latter group decidedly more bearish. Again, which side you want to believe?

Back to the markets, one has to enjoy the days with US GDP revised lower (-6.3%) and weekly jobless claims stood at horrible 650K level, while S&P extended the come-back rally 2.3% to 833 on Thursday. Obviously, this view of a BTE cyclical recovery into mid-2010 was taken by the investors after two pleasant surprise – 1) durable good orders (+3.9% in Feb vs. -5.9% in Jan) and 2) new home sales (337K vs. cons 300K). These follow the recent data (esp. PMI) suggest that monetary and fiscal stimulus may work to assist growth in the period from 2H09 -1H10, given the powerful base effect created by the speed and depth of the 2H08 industrial production collapse. As a result, I started to see EM asset prices are now responding positively. But with QEs and the asset purchase programs now priced in, I think the risk is whether these plans will eventually disappoint to investors?

Let us take a look of x-asset markets before moving on… Global equities climbed 4.4% higher this week and 10.7% this month, but are still down 5.7% ytd. Regionally, equities rose 11% in US this month, +13.1% in Japan and +7.21% in EU. UST yields closed higher wow but significantly lower mom with 2yr (+3bp) and 10yr (-12bp) yields closed at to 0.90% and 2.74%. DXY has levelled off this week, after declining 4% over the previous two weeks. USD has declined 5% mom to EUR 1.328 while remained flat vs. YEN to 97.86. 1MWTI oil climbed 1.32$ to $52.38/bbl—+16.3% higher since February. Industrial metals are also up considerably (10%) this month, led by an 18% rise in copper prices. In contrast, precious metals and agriculture commodities are about flat over the same period.

In my own view, after the recent rally for 2 weeks, I am getting uncomfortable with more and more investors falling over themselves calling for the rally to continue or call for a new bull market here, including Templeton Mark Mobius. I think I am happy to take profit here and wait for a 10% pullback to decide what to do. But on the Chinese market front, I am anticipating more positive macro news flow in the very near-term, thus one may be able to ride the trend for a while. Having said so, the development in the US remained the market focus as nobody can be confident that the US yet has a workable solution to its banking disaster. As I mentioned, the professional world has a plenty of scepticism on the Geithner plans, including 1) inadequate; 2) untested; 3) requires investors to take regulatory risk; 4) just launches what was widely expected; 5) exit strategy? Nobel Prize winner Joseph Stiglitz and Paul Krugman both said that Geithner's plan is unlikely to work as long as the economy remains weak and they predicted the US economy won’t stabilize until late this year. In addition, Martin Wolf at FT also claimed that a successful bank rescue is still far away. I think these voices are accepted by rating agency as BoA (from A1 to A2) and Wells (from Aa3 to A1) get downgraded by Moody's on concern that they will need more TARP funds! In fact, the Geithner plan is now being viewed as the US government providing non-recourse finance to private-investment partners who are, in effect, being offered the next asymmetric financial bet. In other words, if things do not work well, it is US tax payers bear all the pains…This is why private equity investors are reacting actively!

Looking ahead, in the very short-term, I think it is too early to fade the authorities/rally, but I would turn into cautious again based on several inconsistencies in the markets – 1) the VIX failed to break the 40-mark during this bear market rally. It was below 40 when the market peaked at the start of 2009; 2) TED spread at 104 bps is well above the mid-Feb low of 91 bps and corporate spreads have stayed wide (NA HY=1367bp) compared with 1188bp at the end of 2008; 3) the unprecedented plunge in corporate profits- After-tax profits, -74% yoy in 4Q08; and 4) UNE rate will likely hit a 26-year high in March of 8.6%. As a result, I seriously doubt the "V" shaped recovery. If this now an 18-month crisis has three parts -- financial collapse, economy recession and a final exit, then the first two stages are now overlapping with negative feedbacks in both directions. In my own view, despite a powerful and coordinated policy response, there are several risks to be watched during the next 6-9 months, including 1) Long-U vs. Short-V: The equity rally appears to price a sharper rally back in profits which economists don’t see, given the WTE jobless claims. So the remaining question is whether or not we shall see the sharper than expected pick-up that we are expecting in 2H09 – 2010; 2) TALF vs. New Securitization: even equipped the TALF program, the new purchase mtg application was down 15% last week, even though refinancing was up 41.5%. In addition, the actions taken by US government --- Fed’s MBS purchasing program and US deficits could make banks less likely to succeed in the new securitization and make bank loan less likely to grow as corporates borrowing get crowded out; 3) Inflation vs. Deflation: the fiscal and monetary actions taken by the US and by China may indeed work in stabilizing their respective economies but it might not save the rest of the world. Thus, although there seems a risk of hyper inflation if Fed and central banks don’t react to bigger growth quickly down the road, I think this view misses the huge output gap created by unemployment and the drop in trade. It’s clear that headline inflation will be negative in 2009 and most of 2010.

A Foundation for Improvement?

The recent data flow continues to be somewhat more positive, giving hope that a foundation is being laid for continued improvement down the road. In Euro area, flash composite PMI rose 1.4% in March, the first meaningful gain in over a year. The increase follows by 1 to 3 months similar turns in US, Japan, UK and emerging-economy PMIs. In addition, the latest US Feb durable goods orders seem to fit the PMI script. Core orders jumped for the first time in six months, including for capital goods. To be sure, the orders trend remains extremely negative. As such, it is becoming increasingly likely the rate of decline in the world economy, while still rapid, has stabilized. Beside that, February US housing market data also give hope that the slide in sales and construction might finally be over. Yes, the 12.2-month existing home supply is still an issue, but the ratio (inventory/sales) is being distorted up by low sales. With median price is now back down to 2003 levels, partially explaining why mortgage applications surged 32.2% last week, the key is whether the improvement in housing affordability and financing can overcome the negative impulse from the labour market.

Another important development has been the recent firming in consumer spending, as seen in monthly retail sales. But the problem is that I continue to see manufacturing and trade flows are falling rapidly because firms are cutting inventory. Last week, WTO predicts global trade will side 9% this, the most pessimistic report on global trade in its 62-year history. That is not a surprise to me as 4Q08 US exports were down a whopping 23.6% in contrast to a 3% increase in 3Q, while imports fell 17.5% during the same period. In Asia, HK Feb export worsened to -23% yoy (-21.8% in Jan, the steepest fall in almost 54 years. The sales, trade and export data are important as in essence, the business cycle is the inventory cycle. Thus, the best news about US durable goods data was not so much in the orders data but in the inventory data, which fell 0.9% mom in February and 1.1% mom in January. This is a very impressive performance considering that shipments droped 0.5% mom and 5.2% mom in these two months, respectively.

In fact according to Mrs. Yellen, the collapse in trade flows since September has been disproportional to the collapse in domestic demand in the respective export markets. She comments that the collapse remains somewhat of a puzzle to Fed as normally trade always contracts by more than domestic demand because of its high-income elasticity. But in this downturn, the drop has been unprecedented and has stunned Fed officials. BDIY since March 06 has dropped 26/5% from 2122 to 1678.

TARP-III and Its Weakness

Fixed income investors start to protest the huge amount of sovereign issue as the auction of 5yr UST notes resulted in a much higher yield (1.849% vs. expectation =1.801%). This is in spite of the Fed buying $7.5bn of USTs. Meanwhile, for the first time in almost 7 years, UK couldn’t find enough buyers for an auction of 1.75bn pounds ($2.55bn) of bonds 40yr gilts. The yield on 10yr gilts rose after the sale by as much as 20bp to 3.53%, the highest since March 5.

Having discussed so, there is doubt to the TARP-III which is intended to buy "toxic" bank assets, while TARP-II injected equity into banks and nearly all of the $700bn of TARP funding has been allocated. It is difficult to see why banks would be willing sellers of double digit returns to investors with less leverage and comparable funding from the FDIC guarantee for loans. Thus, credit conditions are likely to remain strained and the future structure of the mortgage market is uncertain, with roughly 40% of the committed to temporary government sponsored structures. In short, the main weakness of TARP III is that the program does little to solve the fire sale price of assets. Not only has the pricing issue not being addressed, but the size of $500bn (or even $1trn) may not have much impact as expected. With the top 6 US banks having $3.8trn of securities and $3.4trn of loans on their balance sheets, $500bn is just like a small drop in the ocean! [Note: Citi= Securities $988bn + Loans $738bn; BoA=$468bn+$908bn; JPM=$840bn + $745bn; WFC=$233bn+ $865bn; GS=$748bn +$91bn; MS =$505bn+ $ 39bn.]

Back to our home market, a recent research paper published by Milbank said Asia is about to experience several years of workouts, refinancing, debt exchanges and bankruptcies in its corporate sector. The process has started in the US, but it will soon hit Asia like a tsunami and one of the most vulnerable segments are Chinese companies who raised cash offshore before the authorities closed that channel of "capital leakage". In another special report on March 18, Fitch Ratings studied 145 rated corporate issuers and found that in 2010 about half of these companies have refinancing requirements that are particularly reliant upon the strength of each country's banking system and continuing good banking relationships or government support. The key is that this is based on bank debt, not bonds. Thus although Fitch is right to emphasise the preponderance of bank debt rather than bond interest and principal owed by Asian corporates, its analysis misses a key change in ownership of those bank loans that has taken place over the past six years. Since 2003, hedge funds, through their "special situations" arms in Asia, have been prolific buyers of loans, so they will be significant players when terms and covenants need to be renegotiated.

We Have Earnings Slump

The 7.1% rally of S&P500 on March 23 after the announcement by UST Geithner suggested that investors want to believe that this credit crisis can end, that the global economic collapse will reverse and that the new business cycle can return perhaps with a few more regulations. Looking back, the 7% rally matches 9 previous moves up since Oct2007 when the DJIA printed the highs. Unfortunately we remain almost 50% below there. Now, with QE and the toxic asset plan now priced into markets, the risk-reward has turned negative once again and here are why.

First, hedge funds may see even bigger withdrawals this year than last based on Deutsche Bank survey, which indicated >82% HF managers expect redemptions were the biggest issue and more than $200bn to be withdrawn, after a net $155bn was taken out last year. Second, with 4Q08 corporate America’s profits (EBT) dropped 16.5% QoQ and -1.5% yoy, S&P 500 companies are projected to report profit decreased 36% on average in 1Q09 and 30% in 2Q09, according to BBG, bringing the total slump to nine straight quarters. Furthermore, it is clear now that not only have EMs failed to decouple, but in many respects, they are behaving like a leveraged play on the downturn in DMs as export growth collapses and external credit constraints strangle domestic demand. This has been reflected by the Chinese corporate profit as well. According to MoF, in 2M09 SOEs realized revenues of Rmb2.74trn and net profits 127.8bn, down 8.1% and 43.7% yoy respectively. [Oil & Ga= -86.1%; Chemicals= -49.3%; Building material= -3.6%; Telecom Equ= -96.3%; Special Equi =-13.4%; Transportation = -40.4%; Power= -77.0%; Coal=+15.0%]. In fact, as of 25March, 537 companies (33% of total domestic listings) have published 2008 annual reports, Sales and earnings quality are still low in 2008, and the poor quality GDP growth driven by policy stimulus won't make much difference to the earnings recession path in 2009. It is now expected that CSI 300 EPS and HSCEI EPS to fall by 15.4% and 26.6%, respectively, in 2009. .

In the near-term, as fiscal stimulus measures kick in, I expect Chinese manufacturing PMI to rebound back above 50, indicating that the Chinese economy is resuming its expansion after contracting sequentially for five consecutive months. Key sector wise, according to NBS, SH’s vacancy floor space jumped 48.4% yoy to 11mn sqm by the end of 2008 (vs. national wide =21.8% yoy), of which, residential VFS up 82.3% yoy (vs. national=32.3% yoy). More importantly, property prices of tier-2 cities accelerated to drop, down 4.1% MoM. In addition, power generation output dropped 3.7% yoy in 2M09 vs. 8.6%/9.8% yoy drop last Nov/Dec. Power consumption fell a moderated 5.2%, with some provinces showing yoy recoveries. Stock wise, I expect IPPs to see significant earnings recover in 2009 after a 45% fall in the spot coal price since Oct 08 and two tariff hikes in Jul-Aug…Lastly MSCI China is now traded at 12.5XPE09 and -0.1% EPSG, CSI 300 at 18XPE09 and +10.2%EPSG, and H-shares at 12.6XPE09 and -2.7%EPSG, while regional market is traded at 14.6XPE09 and -10.5% EPSG.

The Repetition of 2001-02

The currency world has a double-barrelled news flow from China last week. First, it looks like China will back-stop the IMF. Second, China is pushing for a reconsideration of the reserve role of SDRs within the IMF. I think the reality is that nothing will happen soon but longer-term China is clearly looking to reduce its exposure to the US$ and reshape the global monetary landscape. I think this has a profound implication of global asset markets as if RMB is going stronger over the medium term and, if that is the case, here in HK, I m ultimately going to see a change in the HKD peg. Such a change, in my own view, is very bullish for both RMB and HKD assets, property and stock, in exactly the same way that it happened in Japan.

But in the near term, the key is still the prospects of USD. As discussed above, the decision by the Fed to move to a full-blown QE policy by buying USTs is bearish for USD, because 1) it raises the concern whether the US is monetizing its increasing fiscal deficit, and 2) Fed’s QE policy will most likely not be replicated by several other major central banks such as ECB, RBA and RBNZ. That being said, however I do not expect the USD sell-off is going to be a straight line. From 3Q08 to 1Q09, USD strengthened due to the global recession, investor repatriation, deleveraging and downside surprises outside of US. So far, he world economy is still in the midst of a global recession, deleveraging has further legs and there will be more bad news out of e.g. Europe and Asia. However, it seems that QE and other govt measures like PPIP could provide a ST floor under global risk appetite. Going forward, as deleveraging could be more orderly than in 4Q08 and 1Q09 and some tentative signs that global economic expectations are stabilizing; the USD could see a repetition of 2001-2002 where DXY remained strong through the US recession in 2001 but started to fall when the world economy recovered in 2002.

Good night, my dear friends!